Global Financial Crisis

The global economic crisis has yet to bottom out. The major industrial economies are in a deep recession, and growth in the developing world is slowing dramatically. The danger of falling into a deflationary trap cannot be dismissed for many important economies. Firefighting remains the order of the day, but it is equally urgent to recognize the root causes for the crisis and to embark on a profound reform of the global economic governance system.

To be sure, the drivers of this crisis are more complex than some simplistic explanations pointing to alleged government failure suggest. Neither “too much liquidity” as the result of “expansionary monetary policy in the United States”, nor a “global savings glut” serves to explain the quasi-breakdown of the financial system, nor does individual misbehavior. No doubt, without greed of too many agents trying to squeeze double-digit returns out of an economic system that grows only in the lower single-digit range, the crisis would not have erupted with such force. But good policies should have anticipated that human beings can be greedy and short-sighted. The sudden unwinding of speculative positions in practically all segments of the financial market was triggered by the bursting of the United States housing price bubble, but all these bubbles were unsustainable and had to burst sooner or later. For policymakers who should have known better to now assert that greed ran amok or that regulators were “asleep at the wheel” is simply not credible.

Financial deregulation driven by an ideological belief in the virtues of the market has allowed “innovation” of financial instruments that are completely detached from productive activities in the real sector of the economy. Such instruments favour speculative activities that build on apparently convincing information, which in reality is nothing other than an extrapolation of trends into the future. This way, speculation on excessively high returns can support itself – for a while. Many agents disposing of large amounts of (frequently borrowed) money bet on the same “plausible” outcome (such as steadily rising prices of real estate, oil, stocks or currencies). As expectations are confirmed by the media, so-called analysts and policymakers, betting on ever rising prices appears rather riskfree, not reckless.

Contrary to the mainstream view in the theoretical literature in economics, speculation of this kind is not stabilizing; on the contrary, it destabilizes prices. As the “true” price cannot possibly be known in a world characterized by objective uncertainty, the key condition for stabilizing speculation is not fulfilled. Uniform, but wrong, expectations about long-term price trends must sooner or later hit the wall of reality, because funds have not been invested in the productive capacity of the real economy, where they could have generated increases in real income. When the enthusiasm of financial markets meets the reality of the – relatively slow-growing – real economy, an adjustment of exaggerated expectations of actors in financial markets becomes inevitable.

In this situation, the performance of the real economy is largely determined by the amount of outstanding debt: the more economic agents have been directly involved in speculative activities leveraged with borrowed funds, the greater the pain of deleveraging, i.e. the process of adjusting the level of borrowing to diminished revenues. As debtors try to improve their financial situation by selling assets and cutting expenditures, they drive asset prices further down, cutting deeply into profits of companies and forcing new “debt-deflation” elsewhere. This can lead to deflation of prices of goods and services as it constrains the ability to consume and to invest in the economy as a whole. The only way out is government intervention to stabilize the system by “government debt inflation”.

The global financial crisis arose amidst the failure of the international community to give the globalized economy credible global rules, especially with regard to international financial relations and macroeconomic policies. The speculative bubbles, starting with the United States housing price bubble, were made possible by an active policy of deregulating financial markets on a global scale, widely endorsed by Governments around the world. The spreading of risk and the severing of risk – and the information about it – were promoted by the use of “securitization” through instruments such as residential mortgages-backed securities that seemed to satisfy investors’ hunger for double-digit profits. It is only at this point that greed and profligacy enter the stage. In the presence of more appropriate regulation, expectations on returns of purely financial instruments in the double-digit range would not have been possible.

With real economic growth in most developed countries at under 5 per cent, such expectations are misguided from the beginning. It may be human nature to suppress frustrations of the past, but experts, credit rating agencies, regulators and policy advisors know that everybody cannot gain above average and that the capacity of the real economy to cope with incomes earned from exaggerated real estate and commodity prices or misaligned exchange rates is strictly limited. The experience with the stock market booms of the “new economy” should have delivered that lesson, but instead a large number of financial market actors began to invest their funds in hedge funds and “innovative financial instruments”. These funds needed to ever increase their risk exposure for the sake of higher yields, with more sophisticated computer models searching for the best bets, which actually added to the opaqueness of many instruments. It is only now, through the experience of the crisis, that the relevance of real economic growth and its necessary link to the possible return on capital is slowly coming to be understood by many actors and policymakers.

The crisis has made it all too clear that globalization of trade and finance calls for global cooperation and global regulation. But resolving this crisis and avoiding similar events in the future has implications beyond the realm of banking and financial regulation, going to the heart of the question of how to revive and extend multilateralism in a globalizing world.

Genesis of global financial crisis

The proximate cause of the current financial turbulence is attributed to the sub-prime mortgage sector in the USA. At a fundamental level, however, the crisis could be ascribed to the persistence of large global imbalances, which, in turn, were the outcome of long periods of excessively loose monetary policy in the major advanced economies during the early part of this decade (Mohan, 2007, Taylor, 2008).

Global imbalances have been manifested through a substantial increase in the current account deficit of the US mirrored by the substantial surplus in Asia, particularly in China, and in oil exporting countries in the Middle East and Russia (Lane, 2009). These imbalances in the current account are often seen as the consequence of the relative inflexibility of the currency regimes in China and some other EMEs. According to Portes (2009), global macroeconomic imbalances were the major underlying cause of the crisis. These saving-investment imbalances and consequent huge cross-border financial flows put great stress on the financial intermediation process. The global imbalances interacted with the flaws in financial markets and instruments to generate the specific features of the crisis. Such a view, however, offers only a partial analysis of the recent global economic environment. The role of monetary policy in the major advanced economies, particularly that in the United States, over the same time period needs to be analysed for a more balanced analysis.

Following the dot com bubble burst in the US around the turn of the decade, monetary policy in the US and other advanced economies was eased aggressively. Policy rates in the US reached one per cent in June 2003 and were held around these levels for an extended period (up to June 2004). In the subsequent period, the withdrawal of monetary accommodation was quite gradual. An empirical assessment of the US monetary policy also indicates that the actual policy during the period 2002-06, especially during 2002-04, was substantially looser than what a simple Taylor rule would have required. “This was an unusually big deviation from the Taylor Rule. There was no greater or more persistent deviation of actual Fed policy since the turbulent days of the 1970s. So there is clearly evidence that there were monetary excesses during the period leading up to the housing boom” (Taylor, op.cit.). Taylor also finds some evidence (though not conclusive) that rate decisions of the European Central Bank (ECB) were also affected by the US Fed monetary policy decisions, though they did not go as far down the policy rate curve as the US Fed did.

Excessively loose monetary policy in the post dot com period boosted consumption and investment in the US and, as Taylor argues, it was made with purposeful and careful consideration by monetary policy makers. As might be expected, with such low nominal and real interest rates, asset prices also recorded strong gains, particularly in housing and real estate, providing further impetus to consumption and investment through wealth effects. Thus, aggregate demand consistently exceeded domestic output in the US and, given the macroeconomic identity, this was mirrored in large and growing current account deficits in the US over the period. The large domestic demand of the US was met by the rest of the world, especially China and other East Asian economies, which provided goods and services at relatively low costs leading to growing surpluses in these countries. Sustained current account surpluses in some of these EMEs also reflected the lessons learnt from the Asian financial crisis. Furthermore, the availability of relatively cheaper goods and services from China and other EMEs also helped to maintain price stability in the US and elsewhere, which might have not been possible otherwise. Thus measured inflation in the advanced economies remained low, contributing to the persistence of accommodative monetary policy.

The emergence of dysfunctional global imbalances is essentially a post 2000 phenomenon and which got accentuated from 2004 onwards. The surpluses of East Asian exporters, particularly China, rose significantly from 2004 onwards, as did those of the oil exporters. In fact, Taylor argues that the sharp hike in oil and other commodity prices in early 2008 was indeed related to the very sharp policy rate cut in late 2007 after the sub-prime crisis emerged.  It would be interesting to explore the outcome had the exchange rate policies in China and other EMEs been more flexible. The availability of low priced consumer goods and services from EMEs was worldwide. Yet, it can be observed that the Euro area as a whole did not exhibit large current account deficits throughout the current decade. In fact, it exhibited a surplus except for a minor deficit in 2008. Thus it is difficult to argue that the US large current account deficit was caused by China’s exchange rate policy. The existence of excess demand for an extended period in the U.S. was more influenced by its own macroeconomic and monetary policies, and may have continued even with more flexible exchange rate policies in China. In the event of a more flexible exchange rate policy in China, the sources of imports for the US would have been some countries other than China. Thus, it is most likely that the US current account deficit would have been as large as it was – only the surplus counterpart countries might have been somewhat different. The perceived lack of exchange rate flexibility in the Asian EMEs cannot, therefore, fully explain the large and growing current account deficits in the US. The fact that many continental European countries continue to exhibit surpluses or modest deficits reinforces this point.

Apart from creating large global imbalances, accommodative monetary policy and the existence of very low interest rates for an extended period encouraged the search for yield, and relaxation of lending standards. Even as financial imbalances were building up, macroeconomic stability was maintained. Relatively stable growth and low inflation have been witnessed in the major advanced economies since the early 1990s and the period has been dubbed as the Great Moderation. The stable macroeconomic environment encouraged underpricing of risks. Financial innovations, regulatory arbitrage, lending malpractices, excessive use of the originate and distribute model, securitisation of sub-prime loans and their bundling into AAA tranches on the back of ratings, all combined to result in the observed excessive leverage of financial market entities.

Components of the crisis

Most of the crises over the past few decades have had their roots in developing and emerging countries, often resulting from abrupt reversals in capital flows, and from loose domestic monetary and fiscal policies. In contrast, the current ongoing global financial crisis has had its roots in the US. The sustained rise in asset prices, particularly house prices, on the back of excessively accommodative monetary policy and lax lending standards during 2002-2006 coupled with financial innovations resulted in a large rise in mortgage credit to households, particularly low credit quality households. Most of these loans were with low margin money and with initial low teaser payments. Due to the “originate and distribute” model, most of these mortgages had been securitized. In combination with strong growth in complex credit derivatives and the use of credit ratings, the mortgages, inherently sub-prime, were bundled into a variety of tranches, including AAA tranches, and sold to a range of financial investors.

As inflation started creeping up beginning 2004, the US Federal Reserve started to withdraw monetary accommodation. With interest rates beginning to edge up, mortgage payments also started rising. Tight monetary policy contained aggregate demand and output, depressing housing prices. With low/negligible margin financing, there were greater incentives to default by the sub-prime borrowers. Defaults by such borrowers led to losses by financial institutions and investors alike. Although the loans were supposedly securitized and sold to the off balance sheet special institutional vehicles (SIVs), the losses were ultimately borne by the banks and the financial institutions wiping off a significant fraction of their capital. The theory and expectation behind the practice of securitisation and use of derivatives was the associated dispersal of risk to those who can best bear them. What happened in practice was that risk was parcelled out increasingly among banks and financial institutions, and got effectively even more concentrated. It is interesting to note that the various stress tests conducted by the major banks and financial institutions prior to the crisis period had revealed that banks were well-capitalised to deal with any shocks. Such stress tests, as it appears, were based on the very benign data of the period of the Great Moderation and did not properly capture and reflect the reality (Haldane, 2009).

The excessive leverage on the part of banks and the financial institutions (among themselves), the opacity of these transactions, the mounting losses and the dwindling net worth of major banks and financial institutions led to a breakdown of trust among banks. Given the growing financial globalization, banks and financial institutions in other major advanced economies, especially Europe, have also been adversely affected by losses and capital write-offs. Inter-bank money markets nearly froze and this was reflected in very high spreads in money markets. There was aggressive search for safety, which has been mirrored in very low yields on Treasury bills and bonds. These developments were significantly accentuated following the failure of Lehman Brothers in September 2008 and there was a complete loss of confidence.

The deep and lingering crisis in global financial markets, the extreme level of risk aversion, the mounting losses of banks and financial institutions, the elevated level of commodity prices (until the third quarter of 2008) and their subsequent collapse, and the sharp correction in a range of asset prices, all combined, have suddenly led to a sharp slowdown in growth momentum in the major advanced economies, especially since the Lehman failure. Global growth for 2009, which was seen at a healthy 3.8 per cent in April 2008, is now projected to contract by 1.3 per cent (IMF, 2009c). Major advanced economies are in recession and the EMEs – which in the earlier part of 2008 were widely viewed as being decoupled from the major advanced economies – have also been engulfed by the financial crisis-led slowdown. Global trade volume (goods and services) is also expected to contract by 11 per cent during 2009 as against the robust growth of 8.2 per cent during 2006-2007. Private capital inflows (net) to the EMEs fell from the peak of US $ 617 billion in 2007 to US $ 109 billion in 2008 and are projected to record net outflows of US $ 190 billion in 2009. The sharp decline in capital flows in 2009 will be mainly on account of outflows under bank lending and portfolio flows. Thus, both the slowdown in external demand and the lack of external financing have dampened growth prospects for the EMEs much more than that was anticipated a year ago.

Volatility in capital flows: implications for emerging market economies

Monetary policy developments in the leading economies not only affect them domestically, but also have a profound impact on the rest of the world through changes in risk premia and search for yield leading to significant switches in capital flows. While the large volatility in the monetary policy in the US, especially since the beginning of this decade, could have been dictated by internal compulsions to maintain employment and price stability, the consequent volatility in capital flows impinges on exchange rate movements and more generally, on the spectrum of asset and commodity prices. The monetary policy dynamics of the advanced economies thus involve sharp adjustment for the EMEs.

Private capital flows to EMEs have grown rapidly since the 1980s, but with increased volatility over time. Large capital flows to the EMEs can be attributed to a variety of push and pull factors. The pull factors that have led to higher capital flows include strong growth in the EMEs over the past decade, reduction in inflation, macroeconomic stability, opening up of capital accounts and buoyant growth prospects. The major push factor is the stance of monetary policy in the advanced economies. Periods of loose monetary policy and search for yield in the advanced economies encourages large capital inflows to the EMEs and vice versa in periods of tighter monetary policy. Thus, swings in monetary policy in the advanced economies lead to cycles and volatility in capital flows to the EMEs. Innovations in information technology have also contributed to the two-way movement in capital flows to the EMEs. Overall, in response to these factors, capital flows to the EMEs since the early 1980s have grown over time, but with large volatility (Committee on Global Financial System, 2009).  After remaining nearly flat in the second half of the 1980s, private capital flows jumped to an annual average of US $ 124 billion during 1990-96. With the onset of the Asian financial crisis, total private capital flows fell to an annual average of US $ 86 billion during 1997-2002. Beginning 2003, a period coinciding with the low interest rate regime in the US and major advanced economies and the concomitant search for yield, such flows rose manifold to an annual average of US $ 285 billion during 2003-2007 reaching a peak of US $ 617 billion in 2007. As noted earlier, the EMEs, as a group, are now likely to witness outflows of US $ 190 billion in 2009 – the first contraction since 1988. Amongst the major components, while direct investment flows have generally seen a steady increase over the period, portfolio flows as well as other private flows (bank loans etc) have exhibited substantial volatility. While direct investment flows largely reflect the pull factors, portfolio and bank flows reflect both the push and the pull factors. It is also evident that capital account transactions have grown much faster relative to current account transactions, and gross capital flows are a multiple of both net capital flows and current account transactions. Also, large private capital flows have taken place in an environment when major EMEs have been witnessing current account surpluses leading to substantial accumulation of foreign exchange reserves in many of these economies.

As noted earlier, the policy interest rates in the US reached extremely low levels during 2002 – one per cent – and remained at these levels for an extended period of time, through mid 2004. Low nominal interest rates were also witnessed in other major advanced economies over the same period. The extremely accommodative monetary policy in the advanced economies was mirrored in the strong base money expansion during the period 2001-02 – shortly before the beginning of the current episode of strong capital flows to EMEs. As the monetary accommodation was withdrawn in a phased manner, base money growth witnessed correction beginning 2004. However, contrary to the previous episodes, capital flows to the EMEs continued to be strong. The expected reversal of capital flows from the EMEs was somewhat delayed and finally took place in 2008. Similarly, the previous episode (1993-96) of heavy capital inflows was also preceded by a significant expansion of base money during 1990-94, and sharp contraction thereafter. This brief discussion highlights the correlation between monetary policy cycles in the advanced economies on the one hand and pricing/mispricing of risk and volatility in capital flows on the other hand. At present, monetary policies across the advanced economies have again been aggressively eased and policy interest rates have reached levels even lower than those which were witnessed in 2002. Base money in the US more than doubled over a period of just six months between June and December 2008. Given such a large monetary expansion and given the past experiences, large capital inflows to the EMEs could resume in the foreseeable future, if the unwinding of the current monetary expansion is not made in a timely fashion.

In rapidly growing economies such as India, high real GDP growth needs concomitant growth in monetary aggregates, which also needs expansion of base money. To this extent, the accretion of unsterilised foreign exchange reserves to the central bank’s balance sheet is helpful in expanding base money at the required rate. However, net capital flows and accretion to foreign exchange reserves in excess of such requirements necessitate sterilisation and more active monetary and macroeconomic management. Thus, large inflows of capital, well in excess of the current financing needs, can lead to high domestic credit and monetary growth, boom in stock market and other asset prices, and general excess domestic demand leading to macroeconomic and financial instability. Abrupt reversals in capital flows also lead to significant difficulties in monetary and macroeconomic management.

While, in principle, capital account liberalisation is expected to benefit the host economy and raise its growth rate, this theoretical conjecture is not supported by the accumulated empirical evidence. Despite an abundance of cross-section, panel, and event studies, there is strikingly little convincing documentation of direct positive impacts of financial opening on the economic welfare levels or growth rates of developing countries. There is also little systematic evidence that financial opening raises welfare indirectly by promoting collateral reforms of economic institutions or policies. At the same time, opening the financial account does appear to raise the frequency and severity of economic crises (Obstfeld, 2009). The evidence appears to favour a hierarchy of capital flows. While the liberalisation of equity flows seems to enhance growth prospects, the evidence that the liberalisation of debt flows is beneficial to the EMEs is ambiguous (Henry, 2007; Committee on Global Financial System (2009)).

Reversals of capital flows from the EMEs, as again shown by the current financial crisis, are quick, necessitating a painful adjustment in bank credit, and collapse of stock prices. Such reversals also result in the contraction of the central bank’s balance sheet, which may be difficult to compensate with accretion of domestic assets as fast as the reserves depletion. These developments can then lead to banking and currency crises, large employment and output losses and huge fiscal costs. Thus, the boom and bust pattern of capital inflows can, unless managed proactively, result in macroeconomic and financial instability. Hence, the authorities in the EMEs need to watch closely and continuously financial and economic developments in the advanced economies on the one hand and actively manage their capital account.

To summarise, excessively accommodative monetary policy for an extended period in the major advanced economies in the post dot com crash period sowed the seeds of the current global financial and economic crisis. Too low policy interest rates, especially the US, during the period 2002-04 boosted consumption and asset prices, and resulted in aggregate demand exceeding output, which was manifested in growing global imbalances. Too low short-term rates also encouraged aggressive search for yield, both domestically and globally, encouraged by financial engineering, heavy recourse to securitisation and lax regulation and supervision. The global search for yield was reflected in record high volume of capital flows to the EMEs; since such flows were well in excess of their financing requirements, the excess was recycled back to the advanced economies, leading to depressed long-term interest rates.

The Great Moderation over the preceding two decades led to under-pricing of risks and the new financial and economic regime was considered as sustainable. The combined effect of these developments was excessive indebtedness of households, credit booms, asset price booms and excessive leverage in the major advanced economies, but also in emerging market economies. While forces of globalisation were able to keep goods and services inflation contained for some time, the aggregate demand pressures of the accommodative monetary started getting reflected initially in oil and other commodity prices and finally onto headline inflation. The consequent tightening of monetary policy led to correction in housing prices, encouraged defaults on sub-prime loans, large losses for banks and financial institutions, sharp increase in risk aversion, complete lack of confidence and trust amongst market participants, substantial deleveraging, and large capital outflows from the EMEs. Financial excesses of the 2002-06 were, thus, reversed in a disruptive manner and have now led to the severest post-war recession. In brief, the large volatility in monetary policy in the major reserve currency countries contributed to the initial excesses and their subsequent painful correction.

The relationship between the recent boom and the current delinquencies in subprime mortgages

Recent US mortgage market troubles unsteadied the global economy. Researchers analyzed millions of loan applications to investigate the roots of the crisis. A credit boom may be to blame. Recent events in the market for mortgage-backed securities have placed the US subprime mortgage industry in the spotlight. Over the last decade, this market has expanded dramatically, evolving from a small niche segment into a major portion of the overall US mortgage market. In other words, is the recent experience, in part, the result of a credit boom gone bad? While many would say yes to these questions, rigorous empirical evidence on the matter has thus far been lacking

Credit booms

There appears to be widespread agreement that periods of rapid credit growth tend to be accompanied by loosening lending standards. For instance, in a speech delivered before the Independent Community Bankers of America on 7 March 2001, the then Federal Reserve chairman, Alan Greenspan, pointed to ‘an unfortunate tendency’ among bankers to lend aggressively at the peak of a cycle and argued that most bad loans were made through this aggressive type of lending. Indeed, most major banking crises in the past 25 years have occurred in the wake of periods of extremely fast credit growth. Yet not all credit booms are followed by banking crises. Indeed, most studies find that, while the probability of a banking crisis increases significantly (by 50–75%) during booms, historically only about 20% of boom episodes have ended in a crisis. For example, out of 135 credit booms identified in Barajas et al. (2007) only 23 preceded systemic banking crises (about 17%), with that proportion rising to 31 (about 23%) if non-systemic episodes of financial distress are included. In contrast, about half of the banking crises in their sample were preceded by lending booms. Not surprisingly, larger and longer-lasting booms, and those coinciding with higher inflation and – to a lesser extent – lower growth, are more likely to end in a crisis. Booms associated with fastrising asset prices and real-estate prices are also more likely to end in crises.

The mortgage market

Reminiscent of this pattern linking credit booms with banking crises, current mortgage delinquencies in the US subprime mortgage market appear indeed to be related to past credit growth . After analyzing data from over 50 million individual loan applications it was found that delinquency rates rose more sharply in areas that experienced larger increases in the number and volume of originated loans (Dell’Ariccia et al., 2008). This relationship is linked to a decrease in lending standards, as measured by a significant increase in loan-to-income ratios and a decline in denial rates, not explained by improvement in the underlying economic fundamentals.

In turn, the deterioration in lending standards can be linked to five main factors. Standards tended to decline more where the credit boom was larger. This is consistent with cross-country evidence on aggregate credit booms. Lower standards were associated with a fast rate of house price appreciation, consistent with the notion that lenders were to some extent gambling on a continuing housing boom, relying on the fact that borrowers in default could always liquidate the collateral and repay the loan. Changes in market structure mattered: lending standards declined more in regions where large (and aggressive) previously absent institutions entered the market. The increasing recourse by banks to loan sales and asset securitization appears to have affected lender behaviour, with lending standards experiencing greater declines in areas where lenders sold a larger proportion of originated loans. Easy monetary conditions seem to have played a role, with the cycle in lending standards mimicking that of the Federal Fund rate. In the subprime mortgage market most of these effects appear to be stronger and more significant than in the prime mortgage market, where loan denial decisions seem to be more closely related to economic fundamentals.

These findings are consistent with the notion that rapid credit growth episodes, due to the cyclicality of lending standards, might create vulnerabilities in the financial system. The subprime experience demonstrates that even highly-developed financial markets are not immune to problems associated with credit booms.

Bank risk models failed

Greenspan and others have questioned why risk models, which are at the centre of financial supervision, failed to avoid or mitigate today’s financial turmoil. There are two answers to this, one technical and the other philosophical. Neither is complex, but many regulators and central bankers chose to ignore them both.

The technical explanation is that the market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them. This was not a bad approximation in 1952, when the intellectual underpinnings of these models were being developed at the Rand Corporation by Harry Markovitz and George Dantzig. This was a time of capital controls between countries, the segmentation of domestic financial markets and – to get the historical frame right – it was the time of the Morris Minor with its top speed of 59mph. In today’s flat world, market participants from Argentina to New Zealand have the same data on the risk, returns and correlation of financial instruments, and use standard optimization models, which throw up the same portfolios to be favoured and those not to be. Market participants do not stare helplessly at these results. They move into the favoured markets and out of the unfavoured. Enormous cross-border capital flows are unleashed. But under the weight of the herd, favoured instruments cannot remain undervalued, uncorrelated and lowrisk. They are transformed into the precise opposite.

When a market participant’s risk model detects a rise in risk in his or her portfolio, perhaps because of some random rise in volatility, and he or she tries to reduce his exposure, many others are trying to do the same thing at the same time with the same assets. A vicious cycle ensues as vertical price falls, prompting further selling. Liquidity vanishes down a black hole. The degree to which this occurs has less to do with the precise financial instruments and more with the depth of diversity of investors’ behaviour. Paradoxically, the observation of areas of safety in risk models creates risks, and the observation of risk creates safety. Quantum  physicists will note a parallel with Heisenberg’s uncertainty principle.

Policy-makers cannot claim to be surprised by all of this. The observation that market-sensitive risk models, increasingly integrated into financial supervision in a prescriptive manner, were going to send the herd off the cliff edge was made soon after the last round of crises. Many policy officials in charge today responded then that these warnings were too extreme to be considered realistic.

The reliance on risk models to protect us from crisis was always foolhardy. In terms of solutions, there is only space to observe that if we rely on market prices in our risk models and in value accounting, we must do so on the understanding that in rowdy times central banks will have to become buyers of last resort of distressed assets to avoid systemic collapse. This is the approach upon which we have stumbled. Central bankers now consider mortgage-backed securities as collateral for their loans to banks. But the asymmetry of being a buyer of last resort without also being a seller of last resort during the unsustainable boom will only condemn us to cycles of instability.

The alternative is to try to avoid booms and crashes through regulatory and fiscal mechanisms which counter the incentives that induce traders and investors to place highly leveraged bets on what the markets currently believe is a ‘sure thing’. This sounds fraught with regulatory risks, and policy-makers are not as ambitious as they once were. We no longer walk on the moon. Of course, President Kennedy’s 1961 ambition to get to the moon within the decade was partly driven by a fear of the Soviets getting there first. Regulatory ambition should be set now, while the fear of the current crisis is fresh and not when the crisis is over and the seat belts are working again.

September 24-25. At the Group of 20 Summit held in Pittsburgh, world leaders agreed to make the G-20 the leading forum for coordinating global economic policy; not to withdraw stimulus measures until a durable recovery is in place; to co-ordinate their exit strategies from the stimulus measures; to harmonize macroeconomic policies to avoid imbalances (America’s deficits and Asia’s savings glut) that worsened the financial crisis; and to eliminate subsidies on fossil fuels (only in the medium term). In trade, there was only a weak commitment to get the Doha round of multilateral trade negotiations at the World Trade Organizations back on track by 2010, and for the International Monetary Fund, the leaders pledged to provide the “under-represented” mostly developing countries at least 5% more of the voting rights by 2011. The other large institutional change was the ascension of the Financial Stability Board, a group of central bankers and financial regulators, to take a lead role in coordinating and monitoring tougher financial regulations and serve, along with the International Monetary Fund, as an early-warning system for emerging risks.

September 18. According to the Economist Intelligence Unit, the aggressive measures that governments have taken to counter the financial crisis have not only helped to prevent a more severe downturn but are now setting the stage for a recovery, albeit a weak one. However, the world economy could weaken again once the stimulus wears off, mainly because government debt has increased dramatically in many countries—eliciting rising concerns about the solvency of the state. This has made current levels of stimulus through government spending not sustainable.

September 16. Investors turned bearish on the U.S. dollar as signs of a recovery in the global economy reduced demand for the currency as a refuge.

September 14. President Obama pushed for financial interests and lawmakers to act on proposals to reshape financial regulation to protect the nation from a repeat of the excesses that drove Lehman Brothers into bankruptcy and wreaked havoc on the global economy last year.

August 27. The Federal Deposit Insurance Corporation revealed that the number of U.S. banks at risk of failing reached 416 during the second quarter 2009.

This global financial and economic crisis has brought to the public consciousness several arcane financial terms usually confined to the domain of regulators and Wall Street investors. These terms lie at the heart of both understanding and resolving this financial crisis and include:

Systemic risk: The risk that the failure of one or a set of market participants, such as core banks, will reverberate through a financial system and cause severe problems for participants in other sectors. Because of systemic risk, the scope of regulatory agencies may have to be expanded to cover a wider range of institutions and markets.4

Deleveraging: The unwinding of debt. Companies borrow to buy assets that increase their growth potential or increase returns on investments. Deleveraging lowers the risk of default on debt and mitigates losses, but if it is done by selling assets at a discount, it may depress security and asset prices and lead to large losses. Hedge funds tend to be highly leveraged.

•Procyclicality: The tendency for market players to take actions over a business cycle that increase the boom-and-bust effects, e.g. borrowing extensively during upturns and deleveraging during downturns. Changing regulations to dampen procyclical effects would be extremely challenging.5

Preferred equity: A cross between common stock and debt. It gives the holder a claim, prior to that of common stockholders, on earnings and on assets in the event of liquidation. Most preferred stock pays a fixed dividend. As a result of the stress tests in early 2009, some banks may increase their capital base by converting preferred the global financial crisis. CDOs are assigned different risk classes or tranches, with “senior” tranches considered to be the safest. Since interest and principal payments are made in order of seniority, junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk. Investors, pension funds, and insurance companies buy CDOs.

•Credit default swap (CDS): A credit derivative contract between two counterparties in which the buyer makes periodic payments to the seller and in return receives a sum of money if a certain credit event occurs (such as a default in an underlying financial instrument). Payoffs and collateral calls on CDSs issued on sub-prime mortgage CDOs have been a primary cause of the problems of AIG and other companies.

Global financial markets

• Rapid growth of speculative lending and deregulation of financial market over the past couple of decades
• Increase in global liquidity and risk appetite e.g. subprime lending and mortgage-backed securities
• Comprehensive and global crisis, encompassing the banking sector, securities and currency markets, and institutional and individual investors in most parts of the world
• Impact of the crisis on growth in the United States and its global spillovers to other parts of the world through international trade and financial system

Developing countries 

Degree and nature of impact depend on the following factors:

• Degree of financial markets integration in the global market e.g. Brazil, China, India are likely to experience immediate impact
• Particular sectors e.g. tourism and mining, as well as informal sector
• Whether economies depend on remittances
• Level of dependency on food and fuel imports
• Pressure on government budget expenditure due to falling revenue as a result of the economic slow down
• Vulnerabilities of particular social groups and/or populations

Impact on MFI  

The global financial crisis affected microfinance institutions (MFIs) as lending growth was constrained by scarcer borrowing opportunities, while the economic slowdown negatively impacted asset quality and profitability. It also brought to the fore the relatively high interest rates that MFIs charge to their (low-income) customers.

Microfinance institutions (MFIs) provide financial services to low-income, economically active, borrowers who seek relatively small amounts to finance their businesses, manage emergencies, acquire assets, or smooth consumption (CGAP 2002). These borrowers usually lack credit histories, collateral, or both, and thus, do not have access to financing from mainstream commercial banks (Banerjee and Duflo, 2007). For this reason, MFIs are seen as playing a role in the creation of economic opportunity, and in poverty alleviation. Recognizing the importance that a number of donors had placed on microfinance as a tool to achieve the millennium development goals (MDGs), the United Nations declared 2005 as the “year of micro-credit”. (Morduch, 1999; United Nations, 2006). MFIs are a heterogenous group that includes different types of institutions (e.g., banks, rural banks, non-bank financial institutions –NBFIs-, non-government organizations –NGOs-, credit unions, cooperatives), legal status (some are regulated and other unregulated), and purpose (including for profit and non profit institutions). MFIs lending portfolios vary greatly depending on the type of institution: banks and NBFIs usually concentrate on larger clients (including small enterprises), while loan sizes per client in cooperatives and NGOs are smaller (in particular as the latter are more likely to lend to groups). That said, lending portfolios of cooperatives and NGOs also differ, as the former are mostly member-based institutions that favor consumption smoothing to a larger extent than other microfinance providers.

Location contributes to heterogeneity, as MFIs adapt to different national regulations, and operate in countries with diverse access to international capital markets. Additionally, MFIs include both mature and young institutions, as the boom observed in this industry for the most part of the last two decades implied that a large number of new institutions entered into a market in which a number of mature institutions had operated for some time, and thus had time to build a reputation, and to “learn by doing”.

From a macroeconomic perspective, this boom has meant that for some countries, microcredit has come to represent a significant portion of both gross domestic product (GDP) and of total credit to the private sector (Figure 1). For these countries, that include low-income countries (LICs) (e.g., Bolivia, Cambodia, Kenya, Mongolia Nicaragua, Tanzania, Vietnam), transition economies (e.g. Armenia, Bosnia & Herzegovina, Kyrgyz Republic, Tajikistan) and emerging economies (e.g. Peru), abrupt changes in microcredit could have macroeconomic implications, as a large number of borrowers (usually larger than those served by banks) are either incorporated to or excluded from credit markets.2 Conversely, the increase in the size of MFIs balance sheets and a lower reliance on traditional financing sources (like aid agencies and non-profit entities) have increased the exposure of MFIs to changes in domestic and international economic conditions.

The global deleveraging that first hit the world economy in mid-2007 and that accelerated in autumn 2008 could not have been possible without the rare coincidence of a number of market failures and triggers, some reflecting fundamental imbalances in the global economy and others specific to the functioning of sophisticated financial markets. Chief among these “systemic” factors were the full-fledged deregulation of financial markets and the increased sophistication of speculation techniques and financial engineering. Other determinants were also at play, particularly the systemic incoherence among the international trading, financial and monetary systems, not to mention the failure to reform the global financial architecture. Most recently, the emergence of new and powerful economic actors, especially from the developing countries, without the accompanying reform needed in the framework governing the world economy, accentuated that incoherence.

What went wrong: Blind faith in the efficiency of financial markets?

To be sure, the causes of the crisis are more complex than some simplistic explanations based on government failure suggest. For example, if it were true that “too much liquidity” as the result of “expansionary monetary policy in the United States” was responsible for the crisis, the attempt to fight the short-term crisis with a new wave of cheap liquidity would amount to throwing oil on the fire.

The same is true for individual misbehavior. No doubt, without greed, without the attempt of too many agents to squeeze double-digit returns out of an economic system that grows only in the lower single-digit range, the crisis would not have erupted with such force. But good policies should have anticipated that human beings can be greedy and short-sighted. Many people, if promised 25 per cent return on equity (or a paradise on earth) tend to believe it possible without posing critical questions about individual risk and much less about the risk of systemic failure. Such behavior has been evident time and again in modern history and it always ended in economic downturn and crash. The problem is much more that policy makers forget the lessons of the past and are easily seduced by the idea that the economic system could care for itself.

Mainstream economic theory of the past decades even suggested that efficient financial markets would smoothly and automatically solve the most complex and enduring economic problem, namely the transformation of today’s savings into tomorrow’s investment. It assumed that efficient financial markets were sufficient to convince some people to put money aside and others to invest it into the future despite the fact that in the real world the investor is faced by “objective uncertainty” (Keynes, 1930) concerning the returns he can expect and despite the fact that the more people save the lower would be the actual returns (UNCTAD, TDR 2006, annex 2 to chapter I).

Efficient financial markets are expected to overcome the uncertainty about the future and the frequency of crisis in these markets may be the result of the “mission impossible” that is expected from them. Or is their vulnerability mainly due to their scale (which nominally dwarfs the real economy) and their vital role for all other markets at the national and international level? Or do financial markets function in a different way than goods markets, perhaps in a way that systematically encourages the emergence of asset-price bubbles through a herding effect induced by the activity of large-scale investors? Obviously, there are strong arguments for all these hypotheses. However, a brief comparison of the logic of investment in fixed capital in a dynamic evolutionary setting (through traditional banking, i.e. lending money as an intermediary between central banks and savers on the one side and borrowers on the other) and investment in financial markets (through the now-crippled investment banks, for example) explains why capital markets seem bound to fail the more “sophisticated” they are, whereas for the markets for goods and services efficiency can never be too much.

Investment in fixed capital is profitable for the individual investor and society at large if it increases the future availability of goods and services. No doubt, replacing an old machine by a new and more productive one, or replacing an old product by a new one with higher quality or additional features, is risky because the investor cannot be sure that the new machine or the new product will meet the needs of the potential clients. If it does, the entrepreneur gains a temporary monopoly rent until others are in a position to copy his invention. Even if an innovation finds imitators very quickly, this doesn’t create a systemic problem: it may deprive the original innovator more rapidly of parts of his entrepreneurial rent, but for the economy as a whole the quick diffusion of an innovation is always positive as it increases overall welfare and income. The more efficient the market is regarding the diffusion of knowledge, the higher is the increase in productivity and the permanent rise in the standard of living – at least if institutions allow for an equitable distribution of the income gains and the demand that is needed to market smoothly the rising supply of products. However, the accrual of rents through “innovation” in a financial market is of a fundamentally different character. Financial markets are about the effective use of existing information margins concerning existing assets and not about technological advances into hitherto unknown territory. The temporary monopoly over certain information or the better guess of a certain outcome in the market of a certain asset class allows gaining a monopoly rent based on simple arbitrage. The more agents sense the arbitrage possibility and the quicker they are to make their disposals, the quicker the potential gain disappears. In this case, too society is better off, but in a one-off, static sense. Financial efficiency may have maximized the gains of the existing combination of factors of production and of its resources, but it has not reached into the future through an innovation that shifts the productivity curve upwards and that produces a new stream of income. The fatal flaw in financial innovation that leads to crises and collapse of the whole system is demonstrated whenever herds of agents on the financial markets “discover” that rather stable price trends in different markets (which are originally driven by events and developments in the real sector) allow for “dynamic arbitrage”, which entails investing in the probability of a continuation of the existing trend. As many agents disposing of large amounts of (frequently borrowed) money bet on the same “plausible” outcome (such as steadily rising prices of real estate, oil, stocks or currencies) they acquire the market power to move these prices far beyond sustainable levels. In other words, as seemingly irrefutable evidence, such as “rising Chinese and Indian demand for primary commodities”, is factored into the decisions of the market participants and confirmed by analysts presumed to be experts, the media and politicians, betting on ever rising prices seems to be rather riskless.

Contrary to the mainstream view in the theoretical literature in economics, speculation of this kind is not stabilizing, but rather destabilizes prices on the targeted markets. As the equilibrium price or the “true” price simply cannot be known in an environment characterized by objective uncertainty, that main condition for stabilizing speculation is not realized. Hence, the majority of the market participants just extrapolate the actual price trend as long as “convincing” information that justifies the hike allows for a certain degree of self-delusion.

The bandwagon created by uniform, but wrong, expectations about price trends inevitably hit the wall of reality because funds have not been invested in the productive base of the real economy where they could have generated higher real income. Rather, it has only created the short-term illusion of continuously high returns and a “money-for-nothing mentality”. Sooner or later consumers, producers or Governments and central banks will no longer be able to perform at the level of exaggerated expectations because hiking oil and food prices cut deeply into the budgets of consumers, appreciating currencies send current account balances into unsustainable deficit, or stock prices lose touch with any reasonable profit expectation. Whatever the specific reasons or shocks that trigger the turnaround, at a certain point of time market participants begin to understand that “if something cannot go on forever, it will stop”, as it was once put by United States presidential advisor Herbert Stein.

At this point, the harsh reality of a slowly growing real economy catches up with the insistent enthusiasm of financial markets such that an adjustment of expectations becomes inevitable. Hence, the short-term development of the economy is largely hostage to the amount of outstanding debt. The more households, businesses, banks, and other economic agents are directly involved in speculative activities with borrowed funds, the greater the pain of deleveraging, i.e. the process of adjusting the level of borrowing to diminished revenues. A “debt deflation” (Fisher, 1933) sets in that fuels further painful adjustment because debtors try to improve their financial situation by selling assets and cutting expenditure, thereby driving asset prices further down, cutting deep into profits of companies and forcing new debt deflation elsewhere. The result of debt deflation if not stopped early on will be deflation of prices of goods and services as it constrains the ability to consume and to invest for the economy as a whole. Thus, in a debt deflation, the attempts of some to service their debts makes it more difficult for others to service their debts.1 Only Governments can step in and stabilize the system by “government debt inflation”.

“Investment banking”, which became synonymous with “financial modernization”, is only a new term for an old phenomenon. The contribution of investment banks to real economic growth was mostly of the zero sum game type and not productive at all for society at large. Much of “investment banking” was unrelated to investment in real productive capacity; rather, it masked the true, speculative character of the activity and presented what appeared to be an innovation in finance. In fact, there was nothing new in the build-up or the unwinding of markets for the financial instruments that investment banks created. What was new, however, was the dimension through which private households, companies and banks have collectively engaged in what amounts to gambling. This can only be explained by the effects of massive deregulation, driven by the conviction that the freedom of capital flows and the efficient allocation of “savings” is the most important ingredient of successful economies.

What made it worse: global imbalances and the absent international monetary system

Analysis of the economic crisis which first erupted in the developed economies has to begin by recalling the end of the global system of “Bretton Woods”, which had rendered possible two decades of rather consistent global prosperity and monetary stability. Since then it has become possible to identify an “Anglo-Saxon” part of the global economy on the one hand, where economic policy since the beginning of the 1980s was comparatively successful in stimulating growth and jobcreations, and a Euro-Japanese component, where growth remained sluggish and economic policy wavered with no clear or consistent view on how to use the greater monetary autonomy that the end of the global monetary system had made possible.

That the crisis originated in the Anglo-Saxon part of the developed countries was the logical outcome of the full swing towards unrestricted capital flows and unlimited freedom to exploit any opportunity to realize short-term profits. The financial crisis has demonstrated the damaging impact of this “short-termism” on long-term growth. But at the same time it has been the major driving force of the world economy in the last three decades. Without the high level of consumption in the United States, today most of the developed world and many emerging-market economies would have much lower standards of living, and unemployment would be much higher. Indeed, the consumption boom in the United States since the beginning of the 1990s was not well funded from real domestic sources. To a significant degree it was fuelled by the speculative bubbles that inflated housing and stock markets. The “wealth effect” of higher prices for housing or   stocks led households in the United States and in the United Kingdom to borrow and consume far beyond the real incomes that they could realistically expect, given the productivity growth of the real economy and the dismal trends in personal income distribution. With overall household saving rates to close to zero (figure 1.1) consumer demand in both countries expanded rapidly but at the same time the growth process became increasingly fragile because it meant that many households could only sustain their level of consumption by further new borrowing. With open markets and increasing international competition in the markets for manufactures the spending spree eventually boosted borrowing on international markets and led to large current account deficits.

Juxtaposed against the current account deficits and overspending in the Anglo-Saxon economies was thrift elsewhere. Parts of continental Europe, in particular Germany, and Japan engaged in belt-tightening exercises that resulted in slow or no wage growth and sluggish consumption. But, since this policy stance also implied increased cost competitiveness, it yielded excessive export growth and ballooning surpluses in current accounts, thereby piling up huge net asset positions vis-à-vis the overspending nations. In both cases international competitiveness was additionally tuned by temporary exchange rate depreciations fuelled by speculative capital flows triggered by interest rate differentials.

These global imbalances served to spread quickly the financial crisis that originated in the United States to many other countries, because current-account imbalances are mirrored by capital account imbalances: the country with a current-account surplus has to credit the difference between its export revenue and its import expenditure to deficit countries. Financial losses in the deficit countries or the inability to repay borrowed funds then directly feed back to the surplus countries and imperil their financial system.

This channel of contagion has even greater potency owing to the lack of governance in financial relations between countries trading with one another in the globalized economy. The dramatic increase of debtor-creditor relations between countries goes far beyond the fallout from the Anglo-Saxon spending spree and has to do with a phenomenon that is sometimes called “Bretton Woods II” (Folkerts-Landau et al., 2004; and UNCTAD, TDR 2004). Bretton Woods II refers to how developing economies emerging from financial crises since the mid-1990s tried to shelter against the cold winds of global capital markets. For these economies, the only way to combine sufficient stability of the exchange rate with domestic capacity to handle trade and financial shocks and with successful trade performance was to unilaterally stabilize the exchange rate at an undervalued level. This applies to most of the Asian countries that were directly involved in the Asian financial crisis and a number of Latin American countries, but also to China and, to a certain extent, India. The latter two experienced financial crises at the beginning of the 1990s and devalued their currencies significantly before fixing it to the dollar – in the case of China – or engaging in managed floating – in the case of India. Increasing unilateralism around the world in dealing with the implications of global imbalances at the national level further aggravated the crisis (see box 1.2).

Another important reason for growing imbalances is movements of relative prices in traded goods as a result of speculation in currency and financial markets (“carry trade”). The growing disconnection of the movements of exchange rates with their “fundamentals” (mainly the inflation differential between countries) has produced widespread and big movements in the absolute advantage or the level of overall competitiveness of countries vis-à-vis other countries. These changes in the real exchange rates are clearly associated with the growing global imbalances (UNCTAD, TDR 2008).

Speculation in currency markets due to interest rate differentials has produced a specific form of overspending that is now unwinding. In many countries, especially in Eastern Europe, but also in Iceland, New Zealand and Australia, it was profitable for private households and companies to borrow in foreign currencies with low interest rates, such as the Swiss Franc and the yen. With inward capital flows searching for high yield, the currencies of capital-importing countries (which were highinflation countries at the same time) appreciated in nominal and in real terms, and this led to a deterioration of these countries’ competitiveness. With losses of market shares and rising current account deficits their external position became more and more unsustainable. The outbreak of the global financial crisis triggered the unwinding of these speculative positions, depreciated the currencies formerly targeted by carry trade, and forced companies and private households in the affected countries to deleverage their foreign currency positions or to default, which poses a direct  threat to the (mainly foreign) banks in these countries. A case in point is the situation that has recently emerged between East European debtors and their Austrian lenders.

In addition to all these factors, overshooting of commodity prices led to the emergence of – partly very large – current account surpluses in commodity exporting countries over the past five years. When the “correction” came, however, the situation of many commodity producers in the poorer and smaller developing countries rapidly deteriorated. In addition to reduced export revenues, this correction devalues investment in equipment and infrastructure that was directly induced by the demand boom and mushrooming revenues of the last years.

Market Events – September 2008

The causes of the current financial crisis have been attributed to many factors, none of which were caused by money market funds. Nevertheless, money market funds found themselves in the “eye of the storm” on September 15, 2008 and were deeply impacted by a rapid succession of events in the financial markets over the next few days.

These events included the sale of Merrill Lynch to Bank of America on September 13th and 14th in a hastily arranged deal, the bankruptcy filing of Lehman Brothers Holdings, Inc. (Lehman Brothers) on September 15, 2008 and the Federal Reserve bailout of American International Group, Inc. (AIG) on September 16, 2008. On September 16, 2008, the Reserve Primary Fund, one of the oldest money market funds in the U.S., announced that it “broke the buck” due to a write off to zero of debt issued by Lehman Brothers.4 Several other advisers or their related persons entered into support agreements due to holdings of Lehman Brothers and other distressed issuers in order to maintain a stable net asset value. In the days that followed, other financial institutions failed or were acquired by competitors at “fire sale” prices. Two large investment banks, Morgan Stanley and Goldman Sachs also came under pressure due to their exposure to mortgage-backed securities or related credit derivatives, and applied for and were granted status as bank holding companies.

The credit turmoil in general, and the rapid succession of these extraordinary events, resulted in panicked markets, extreme volatility in the equity markets, plunging prices across most asset classes, and essentially frozen credit and securitization markets. Money market funds were subject to intense redemption pressures and on September 18, 2008, Putnam Investments’ Prime Money Market Fund, a $15 billion institutional fund, announced that it was liquidating due to those pressures. Industry participants were deeply concerned that the industry could not sustain a “run” on money funds and that the ripple effects of such a run would be devastating.

Regulatory Response

These events spurred a number of short-term emergency measures designed to “unfreeze” the money markets and credit markets, and are likely to result in long-term reforms focusing on systemic risk management, increased reporting, and greater “transparency” (i.e., access to information in the marketplace and by regulators) with respect to portfolio information and shareholder information. Emergency Measures.

On Friday, September 19, 2008, the U.S. Department of the Treasury announced a temporary guarantee program for money market funds that was designed to guarantee the $1.00 per share value to shareholders holding shares as of September 19, 2008 in participating money market funds at $1.00 per share. The program was designed principally to mitigate fears of additional funds “breaking a buck” and stabilize redemption flows from funds. Substantially all money market funds participated in the program. The program had an initial termination date of April 30, 2009, which was subsequently extended to September 18, 2009. The program, by its terms, is not subject to further extension. In addition, the Federal Reserve established the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility in September, as well as the Commercial Paper Funding Facility and the Money Market Investor Funding Facility in October. These programs were designed to help money market funds meet redemption demands by facilitating the sale of asset backed commercial paper to approved third parties.

The staff of the Commission issued more than twenty-five (25) no-action letters between September 16, 2008 and October 24, 2008, providing emergency relief to money market funds to allow the adviser or its related persons to acquire securities from, or enter into various capital support agreements with, affiliated mutual funds in order to maintain a stable net asset value. These requests generally arose from holdings of Lehman Brothers, AIG, SIVs and other troubled issuers. For the first time, the no-action relief permitted the acquisition of securities by the adviser or its related persons solely for liquidity purposes (i.e., to facilitate redemption requests of the fund). Certain advisers and their related persons were themselves subject to tremendous financial stresses as a result of the credit and market turmoil, and the expectation of support further exacerbated these stresses.

Long-Term Reforms.

Financial crises of this magnitude usually spur significant regulatory reform. Money market funds and their sponsors will be affected by many of the broad regulatory reforms under discussion, as well as by proposals directed specifically at money market funds. Although a wide range of proposals are being considered and debated, some broad themes have emerged. First, regulatory reform will likely focus on risk management practices and systemic risk. The President’s Working Group on Financial Markets concluded that investors failed to conduct comprehensive risk assessments of instruments that were complex, and relied too heavily on credit ratings. The group also noted inadequate stress testing procedures and failure to adequately identify vulnerability to systemwide shocks to markets and market participants. The Group’s report contains a number of recommendations to mitigate systemic risk. The report recommends the establishment of a systemic risk regulator and a centralized capital markets regulator. Industry recommendations, discussed below, also focus on risk management and include a number of recommendations designed to enhance risk management practices, including mandatory stress testing requirements. Regulatory reforms may include additional reporting requirements designed to allow regulators to monitor systemic risk, as well as requirements designed to enhance risk management at individual firms. A second major theme of regulatory reform is transparency. Several groups have proposed more frequent reporting by money market funds of portfolio holdings and other key information to a designated regulator on a more frequent basis. This information could include portfolio holdings, yield, shadow pricing and other information. Such groups recommended that such reports would be filed electronically in a non-public forum. The ICI’s Money Market Report also recommends greater transparency with respect to a money market fund’s client base and proposes that funds be required to adopt “know your client” policies, disclose certain information regarding concentration of clients on their websites, and disclose the risks associated with concentration of clients. Other reforms specific to money market funds have included requiring money market funds to float their net asset values, requiring money market funds to become special purpose banks that are insured and are subject to capital requirements, or requiring advisers to maintain specified capital levels. Commission Chairman Mary Shapiro stated in remarks before the Senate Banking Committee in March the agency will “quickly …. strengthen the regulation of money market funds.” Members of the staff of the Commission have said that “Rule 2a-7 is broken” and have indicated that changes to Rule 2a-7 will be forthcoming, and will likely include certain of the recommendations contained in the Money Market Report.

References and Citations

• The global financial crisis and developing countries – Overseas Development Institute
• Rakesh Mohan: Global financial crisis – causes, impact, policy responses and lessons
• The First Global Financial Crisis of the 21st Century – A VoxEU.org Publication
• Responding to the Global Financial Crisis: The Evolution of Asian Regionalism and Economic Globalization – Gregory Chin
• The Global Financial Crisis and Middle-Income Countries – Alejandro Foxley
• The Global Financial Crisis: Analysis and Policy Implications – Dick K. Nanto
• The global financial crisis and developing countries – Dirk Willem te Velde
• The Global Financial Crisis – Nancy Birdsall
• The Global Economic Crisis: Systemic Failures and Multilateral Remedies – Report by the UNCTAD Secretariat Task Force on Systemic Issues and Economic Cooperation
• The Impact of the Global Financial Crisis on Microfinance and Policy Implications – Gabriel Di Bella